Self-Fulfilling Price Cycles

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Abstract

This paper presents a model of a self-fulfilling price cycle in an asset
market. Price oscillates deterministically even though the underlying
environment is stationary. The mechanism that we uncover is driven by
endogenous variation in the investment horizons of the different market
participants, informed and uninformed. On even days, the price is high;
on odd days it is low. On even days, informed traders are willing to
jettison their good assets, knowing that they can buy them back the
next day, when the price is low. The anticipated drop in price more
than offsets any potential loss in dividend. Because of these asset sales,
the informed build up their cash holdings. Understanding that the market
is flooded with good assets, the uninformed traders are willing to pay a
high price. But their investment horizon is longer than that of the
informed traders: their intention is to hold the assets they purchase,
not to resell. On odd days, the price is low because the uninformed
recognise that the informed are using their cash holdings to cherry-pick
good assets from the market. Now the uninformed, like the informed, are
investing short-term. Rather than buy-and-hold as they do with assets
purchased on even days, on odd days the uninformed are buying to sell.
Notice that, at the root of the model, there lies a credit constraint.
Although the informed are flush with cash on odd days, they are not deep
pockets. On each cherry that they pick out of the market, they earn a
high return: buying cheap, selling dear. However they don't have enough
cash to strip the market of cherries and thereby bid the price up.